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Forget Buy and Hold, Think Buy and Short

Most stocks underperform. Put the odds in your favor by shorting stocks.

And I'm not just talking about my personal portfolio, though I've owned plenty of terrible stocks in my life. No, most stocks really do stink.

In fact, nearly two-thirds of stocks will underperform a diversified index. That's according to a research study by hedge fund Blackstar Funds covering stocks traded on all three major U.S. exchanges from 1983 to 2007 (a very bullish period for the stock market).

What did Blackstar find?

64% of stocks underperformed the Russell 3000 during that span, dividends included.

39% of stocks had a negative lifetime total return. Two out of every five stocks lose money.

18.5% of stocks lost at least 75% of their value. Almost one out of five is a really bad investment.

What's more, the mean compounded annual return of the 8,054 stocks in Blackstar's study was minus 1.06%. Think about that for a second. In the greatest bull market in history, the average U.S. stock actually lost money.

Nope, no silver lining hereHere's where you're probably expecting me to say: "But ignore all these bad statistics. You and I, we can find winning stocks. No problem!"

Hate to break it to you, but only a small sliver of stocks -- 14% to be exact -- delivered compounded annual returns of greater than 20% during the period covered in Blackstar's study. That small cohort was responsible for almost all of the gains of the Russell 3000 from 1983 to 2007.

How hard is it to find a 20% per-year winner? Of the 6,026 stocks on the NYSE and Nasdaq, exactly 249, or about 4% of them, had compounded annual returns of 20% or more over the past 10 years.

Let's take a look at few of the big winners in that magical 249:

Stock

10-Year Annualized Return

Hansen Natural

54%

Green Mountain Coffee Roasters

49%

Bally Technologies(NYSE: BYI)

52%

Urban Outfitters(Nasdaq: URBN)

40%

NetEase.com(Nasdaq: NTES)

39%

Panera Bread(Nasdaq: PNRA)

29%

Goldcorp

28%

Apple

27%

Strayer Education(Nasdaq: STRA)

27%

ITT Educational Services(NYSE: ESI)

22%

Granted, Apple was already a household name in 2000, but that was pre iPod and iPhone, and competitors like Dell and Gateway were eating Apple's lunch in the personal computer market.

If you were savvy enough to spot the gold trend before it really started to take off and ride Goldcorp to huge gains, more power to you. The other names on the list were all small companies back in 2000, and probably not on most investors' radars.

All of this is to say that, out of a large universe of 6,000 stocks, the chance of having even minimal exposure to any of these 249 big winners was slim to none. Because of that, the chance your stock portfolio made you any money for you over the past decade was also just that -- slim to none.

History hates winnersLet's go back even further. Imagine it were 1980 and I told you that in 30 years, Eastman Kodak, Bethlehem Steel, General Motors, Emery Air Freight, Polaroid, and Xerox would either be bankrupt, bailed out by the government, or be trading for less than it was in 1980. You would have called me crazy. These were some of the leading companies of the day.

Look back at that table above of the past decade's big winners. Are companies such as Apple, Goldcorp, Hansen Natural, Urban Outfitters, Panera Bread, and Strayer Education likely to repeat their great performance of the past decade?

Apple would need to sell somewhere on the order of 650 million iPhones over the next 10 years.

Goldcorp's gold production would have to increase by 12 times (not happening) or the price of gold would need to rise to $14,200 (possible, but let's get real).

Hansen Natural would need to sell $90 billion worth of its Monster beverages every year by 2020. That's three times Coca-Cola's current annual sales!

Bally Technologies depends in part on the expansion of casinos in the U.S., something that's not going to happen at near the pace of the previous 10 years.

Urban Outfitters would need to sell more than $30 billion of trendy clothes per year, or more than Gap, Abercrombie & Fitch, and American Eagle sell combined today.

NetEase.com would need to find a way to keep the Chinese government -- which keeps tight control over its media and gaming properties -- off its back. And I've lost count of how many new Chinese online gaming companies there are nowadays.

Green Mountain Coffee Roasters would need to sell $65 billion worth of coffee machines and coffee every year by 2020, or about six times Starbucks' current annual sales!

Panera Bread would need to expand its store base to around 17,600 over the next 10 years, or about half the size of McDonald's current worldwide footprint.

Both Strayer Education and ITT Educational Services have been huge growers, but the recent government furor over the for-profit education industry could throw major roadblocks in their way.

Just look at a few of the big winners from 1983 to 2007 in Blackstar's study: American International Group, Bear Stearns, Citigroup, Fannie Mae, and General Motors. After 2007, one of those companies filed for bankruptcy protection; one was gobbled up by a competitor for pennies on the dollar; and the other three each lost more than 90% of their value.

Stop trying to find winnersIf this data suggests to you that picking individual stocks is a sucker's game, I don't blame you. How many of us are actually smart enough and lucky enough to find those 4% of stocks that will turn out to be big winners? Very few. In fact, you'd be very fortunate to just find one long-term 20% winner in your lifetime.

The key is to stop spending so much fruitless time looking for them. Instead, let's put the odds in our favor and focus on the 64% of stocks that just plain stink. We may even come across some of the really ugly ones -- the one out of five stocks that will go on to lose 75% of their value. Heck, the odds of finding a big loser are almost five times the odds of finding a big winner!

Now, I'm not suggesting you dump all of your long positions and just start shorting stocks. After all, if there weren't great returns to be made buying individual stocks, we'd all stand to make a lot less money and, well, I'd be out of a job.

What I'm suggesting is that you set aside a good chunk of your portfolio for shorts. That will act as a useful hedge against your favorite long positions and give your portfolio a lot of critical ballast during tough times in the market. Just imagine if 20% of your portfolio would have been short going into the 2008 market crash. Imagine how much better we all could have done.

Matthew Argersingerdoesn't own any of the stocks mentioned in this article. Green Mountain Coffee Roasters, Hansen Natural, and NetEase.com are Motley Fool Rule Breakers picks. Apple is a Motley Fool Stock Advisor recommendation. The Fool is short shares of Bally Technologies. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool has adisclosure policy.